Dell Buyout to Test Hawkins’ Buy-and-Hold Math After Drop

Southeastern started buying Dell in the third quarter of 2005 and built its stake to 130.9 million shares by the middle of 2007, when the price ranged from $19.91 to $41.54 a share. Photographer: David Paul Morris/Bloomberg

Jan. 16 (Bloomberg) -- O. Mason Hawkins and G. Staley
Cates, having made Southeastern Asset Management Inc. the
second-largest investor in Dell Inc., told clients last year the
computer maker was worth more than its sliding stock price
suggested when viewed as a private company.

Their math may soon be put to the test.

Dell, based in Round Rock, Texas, is in buyout talks with
private-equity firms, two people with knowledge of the matter
told Bloomberg News this week. A deal could end Southeastern’s
seven-year ownership of Dell shares during which the stock
declined by more than 60 percent.

“I’ve been arguing with them since 2006 that it wasn’t a
smart investment and I didn’t like the way they did their
research,” said Michael Lipper, the head of Lipper Advisory
Services Inc. in Summit, New Jersey. “These people have very
deep beliefs and nothing appears to shake them,” said Lipper,
who says some of his clients have money invested with
Southeastern.

Cates, the firm’s president, and Hawkins, chairman and
chief executive officer, are buy-and-hold investors who tend to
take large positions in individual stocks and stick with them
for a long time. Southeastern has held Dell since the third
quarter of 2005 and owned 7.5 percent of the personal computer
maker as of Sept. 30, according to data compiled by Bloomberg.

‘Marry Stocks’

The investment, along with declines in major holdings such
as General Motors Co. and Chesapeake Energy Corp., held down
returns in recent years as Hawkins and Cates, like other
prominent money managers with strong long-term records,
struggled to beat markets.

“Value investors are prone to marry their stocks and
sometimes find it difficult to part with them,” Geoff Bobroff,
a mutual-fund consultant based in East Greenwich, Rhode Island,
said in a telephone interview.

Southeastern started buying Dell in the third quarter of
2005 and built its stake to 130.9 million shares by the middle
of 2007, when the price ranged from $19.91 to $41.54 a share.
Southeastern’s stake varied in size after that, reaching a high
of 168 million shares at the end of the first quarter of 2009,
when the stock traded at an average price of $9.59 a share.

The company held 130.1 million Dell shares at the end of
September last year, according to SEC filings. Southeastern said
at the end of the third quarter that Dell’s shares in a
conservative valuation were probably worth in the “low $20s,”
according to a regulatory filing.

‘Intrinsic Value’

“We are measuring it mainly on intrinsic value, on what we
expect them to do and how we would view them as a private
company if we owned the whole thing,” Cates said during the
firm’s annual meeting in May for Southeastern clients. “On that
front, they have just blown away all expectations.”

To avoid selling the stock below what the company may be
worth, Southeastern could participate in an LBO by contributing
its current shares for equity in the privately held company, a
step that would also reduce the amount of money the buyout firms
need to raise. Mutual funds are allowed to hold as much as 15
percent of their net assets in illiquid securities, according to
Bobroff, the mutual fund consultant.

Dell ‘Believer’

Holding securities that don’t trade can complicate a mutual
fund’s efforts to determine its daily net asset value, the
figure that dictates how much investors pay to acquire shares in
the fund and receive when they cash out, according to Bobroff.
That may be less of an issue for Southeastern because its
Longleaf Partners fund held just 30.9 million Dell shares as of
Sept. 30, equaling about 3.8 percent of its $8.1 billion in net
assets.

Southeastern held 99.2 million shares in separate accounts
for the firm’s other clients, which range from pension funds,
wealthy individuals and university endowments to sovereign
wealth funds, according to regulatory filings. Such clients
typically don’t raise the same valuation concerns about holding
illiquid stock as investors in a mutual fund might.

“I could see them participating if they were so offered,”
Lipper said of the possibility that Southeastern might join a
leveraged buyout. “They are a believer in Michael Dell.”

‘Patient Investors’

Founded in 1975, Southeastern managed $32.7 billion in
mutual funds and separately managed accounts as of Sept. 30,
according to its website.

Hawkins and Cates are best known for running the Longleaf
Partners Fund. The fund averaged gains of 12 percent a year for
the past 25 years, compared with 9.7 percent for the Standard &
Poor’s 500 Index. For the past five years Longleaf returned 0.3
percent annually while the benchmark climbed 1.7 percent a year.

“They are patient investors and they are not afraid of
controversy,” Russel Kinnel, director of mutual-fund research
at Chicago-based Morningstar Inc., said in a telephone
interview.

The Longleaf fund turns over the stocks in its portfolio
about one-third as often as the typical U.S. diversified mutual
fund, Morningstar data show. The fund is also more concentrated
than peers. Its top 10 holdings represent 56 percent of the
portfolio, compared with 29 percent for peers.

Defending Dell

Southeastern, which is based in Memphis, Tennessee, told
shareholders in a 2005 annual report that its managers wanted to
own Dell for a number of years, describing the company as
“high-quality business,” whose executives had “proven
operational and capital allocation prowess.”

The fund managers have continued to defend Dell as the
stock declined. Hawkins told Southeastern’s shareholders at
their annual meeting in May that Dell was undergoing a
metamorphosis from a personal computer company to a services
firm, and was becoming “the IBM for small and medium-sized
businesses.”

“We will lay a lot of money that it will certainly outgrow
IBM in the next decade,” Hawkins said of Dell at the May
meeting.

Dell declined 68 percent from Sept. 30, 2005, through last
week. The stock jumped 21 percent in the first two trading days
this week, to $13.17, on news of the buyout talks.

Longleaf Partners also paid $213 million in 2011 to
purchase options that entitle it to buy 25 million Dell shares
for $15 each until Dec. 14, 2015. The options, which entitle the
Longleaf fund to buy the Dell shares “in the money” at $7
each, had a market value of $154.7 million as of Sept. 30,
according to regulatory filings. Dell shares closed at $9.86
each on Sept. 28, the last trading day of the month.

Founder’s Stake

Founder Michael Dell is the largest owner of the personal-computer maker with 16 percent of the shares.

Dell was Southeastern’s sixth-largest stock holding as of
Sept. 30, according to a regulatory filing. The biggest holding,
Oklahoma City-based Chesapeake, the second-largest U.S. natural
gas producer, has also had its challenges.

The stock fell 25 percent in 2012 after natural gas prices
plunged and CEO Aubrey McClendon was questioned about potential
conflicts of interest between his personal financial
transactions and corporate duties.

Southeastern, Chesapeake’s biggest shareholder, wrote the
company a letter in May 2012, saying the energy producer should
consider selling itself. Southeastern also advised the company
to spend less time meeting with analysts.

Based on the Chesapeake experience, Morningstar’s Kinnel
said the money managers wouldn’t be shy about offering Dell its
opinion on any buyout offer.

‘Extraordinary Patience’

Longleaf Partners Fund held General Motors shares in the
fourth quarter of 2007, when the carmaker lost 32 percent of its
value, the managers wrote in a 2007 annual letter to
shareholders.

Some of Southeastern’s holdings have fared better. Direct
TV, the largest U.S. satellite-TV operator, has more than
doubled in value since October 2008, according to data compiled
by Bloomberg. The El Segundo, California-based company was the
money manager’s third-largest holding as of Sept. 30.

The fund in 2012 sold Yum! Brands Inc. for a big gain after
holding it for more than a decade, Morningstar analyst Gregg
Wolper wrote in an October note. Yum is a Louisville, Kentucky-based fast-food company.

Wolper, in the same note, said of the fund, “It is
appropriate only for investors who fully understand its strategy
and have extraordinary patience and calm.”